Business
Associations Class Notes
Two
or three loose ends from yesterday:
Would
our client from yesterday have any indemnification rights or rights over the
independent CPA firm, the investment banking firm or the good
The law firm’s role in
offerings
Law
firms seldom say that they’re undertaking a 100% investigation or an
audit. There are exceptions to that: if
there is a sexual harassment claim in a corporation and four of the seven
directors authorized the investigation of the fifth director, then the law firm
will be extremely careful and
investigate the facts fully. Generally
speaking, however, they expressly state in their opinion that they are relying
on facts supplied by officers and in
the normal course of events, if there is nothing strange about what the
officers tell them, they can do so. Both
CPA firms and law firms will sometimes require officers’ certificates. They
will have the officer read, sign and date it.
If you’re an officer, be careful!
In
Sarbanes-Oxley § 404, as to public companies, there has to be a system of firm internal controls established. This has led to an elaborate system of subaffirmations
that top management requires from division managers, addressed to them. This creates additional expense, to the tune
of $4 million a year for a $1 billion company.
For
lawyers, in giving opinions they will negotiate in the initial agreement that
in certain matters they may reasonably rely upon officers’ certificates. That’s a good way to cut down on legal
cost. In a public offering, the outside
law firm’s duties run in two different directions: (1) to the officer and
directors, and (2) to the quasi-client. If
the lawyer knows or reasonably should know that what is being done violates the
law, then the quasi-client (buyer of the security) can sue the lawyer.
In Tomash, which had
to do with indemnification, the director there had asked the lawyer for the
company whether what he was doing was legal, and the lawyer said: “Go ahead, it’s
legal.” The lawyer was wrong, and an SEC
injunction was issued against him. His
best cause of action was against the corporate lawyer who gave the advice, and
then under respondeat superior against the corporation.
What
about the legal opinion to the underwriters?
It’s a long opinion on many
matters. The outside law firm would be liable
to the underwriter. One opinion, for
example, is that the corporation has picked the correct SEC form to file
on. In the case of a mistake, there is
clear liability. Lawyers never opine that there has been full compliance with the federal
securities laws because these laws include anti-fraud
provisions and there’s no way that the lawyer can be clear that he’s getting
the full story from all the officers.
However, the underwriters do require an independent opinion concerning
the truthfulness of the prospectus. “Based
on what we know (without a full audit or full investigation), nothing has come
to our attention that causes us not to believe that the prospectus is truthful
in all material respects.” The next
sentence will say: “The preceding sentence does not relate to the financial
statements.” In the real world, there is
a lot of overlap between the narrative and financial statement portions of the
prospectus, and one of the big issues is whether there was an overlap in the
case we talked about.
What
about the law firm’s liability to the client?
Their opinion is limited and there is probably no possibly of liability. But lawyers can be held liable. One of
the big law firms in
Comfort letters
One
more thing about deals, registered and unregistered:
as to the unaudited interim statements (CPAs only audit
annual statements), you can get a “comfort letter” from the CPA firm. The purchaser will require such a “comfort
letter” concerning the unaudited statements. It reads much like the attorney’s negative
opinion: “We have not conducted an audit or a complete investigation. This is supplied to you alone; nobody else
may rely on it. The opinion may not be
assigned or transferred and it applies only to this deal.” Lawyers in practice refer to this as dealing
with the “sister-in-law problem”. Say
you’re asked for a big opinion for a client.
Suppose the guy gets the opinion and the sister-in-law has a similar
problem, and the guy copies the letter for her, but it doesn’t fit her
situation. If you don’t have that
clause, it’s possible that the sister-in-law can sue you.
They
will also state: “We have conducted certain limited inquiries concerning the unaudited statement.
To the best of our knowledge, in our opinion [to prevent a warranty or contract],
based on what we know, the interim statements contain no material untrue matter
and they are consistent with the
bases on which the audited statements were prepared.”
Comfort
letters are useful for three reasons: (1) The letters
come with a prestigious letterhead. (2) The
accountants take this seriously, even though they don’t audit. (3) You probably trigger R.2d Torts § 552
because the auditing firm is on notice of special
foreseeability.
There
are instances in which it would be wise to get audited statements for the six
month period if you’re really suspicious.
But it will take a while a cost a lot of money. It costs almost as much to certify a six
month period as it does to certify a twelve month period.
Under
Connecting the ’33 and ’34 Acts
In
general, the Securities Act of 1933 deals with offerings by issuers and affiliates of issuers that are public
nature. If an offering is private, 4(1),
4(2) and Rule 506 will usually exempt them.
The Securities Exchange Act of 1934 deals primarily with the day-to-day trading markets, both the stock
exchanges (NYSE, AMEX) and the over-the-counter markets (NASDAQ).
If
you’re a big public company, there is nothing that will exempt you from
registration, but you’ll get shorter forms under the Securities Act of 1933. Be aware of these two forms: under the ’33 Act,
you use S-1 if you can’t find a simpler form.
We have talked about the S-8, which is a simpler form for employee stock
options and employee stock purchase plans.
The S-8 can only be used by public reporting companies.
In
the Securities Exchange Act of 1934, at § 12 we find talk of registration of
securities, too. The big form you use,
either with a stock exchange or with NASD is Form 10 under the ’34 Act. In addition, you will have to file a listing application and signed listing agreement with the stock
exchange or NASD. If you’re a new
company, going public, you usually will list on an exchange or on NASDAQ at the
same time that you have your ’33 Act statement
approved. But you don’t have to say the
same thing three different times. Once your
S-1 is effective, you just fill out the first couple of pages of the Form 10
and listing application and then attach your ’33 Act
statement to it. Then you incorporate by
reference. This information is publicly
available in
At
§ 10(b) of the Securities Exchange Act of 1934, fraud is prohibited in
connection with the purchase or sale of any security by any person. It covers everything! It’s not often useful to plaintiffs due to
the restrictions of the ’95 Act and the fact that you always have to plead
scienter with great particularity. However,
the last two U.S. Supreme Court cases on the subject have turned out to be very
pro-plaintiff. American investors bought
warrants in a
§
14(e) of the Securities Exchange Act of 1934 relates to any tender offer by any
person for any security. If you make a tender
offer to a little company and you use the mails or means of interstate commerce,
you’re covered. But § 14(e) does not
specifically require the use of the mails or interstate commerce. If you’re using it affirmatively, it’s
usually present, so plead it and prove it.
The Supreme Court has held that where the statute doesn’t require an interstate
commerce connection but the plaintiff proves it, you’re okay.
Compare
§§ 12(a)-(b) and 12(g). §§ 12(a)-(b) are
voluntary because no one is required to list their securities on a stock
exchange. § 12 (g) is mainly mandatory
in that if you have over 500 shareholders and over a certain amount of money in
assets, you must file. § 12 (g) also
permits voluntary filing. Why would
anyone want to do that, though? The
answer comes from the Williams Act. The
big deal is §§ 13(a)-(b): public periodic reporting with the SEC is required. Once you go public and list on the NYSE, you’ll
be filing reports thereafter. Under §§
14(a)-(c), you have proxies. Under § 16,
you have insider trading reports. §
16(b) has to do with recapture of short-swing profits. § 16(c) deals with an officer, director, or
10% shareholder and says that a short sale is a crime. A short sale is a sale of stock you don’t
own. You sell short when you think the
stock is going down. In the 1920’s, the
CEO of a company sold his stock short and made a mint! This was deemed “un-American”! Also, you can’t sell “against the box”,
meaning borrowing it from your own stock certificates in your safe deposit
box. You have to actually transfer the
certificate when you sell the stock!
The
Williams Act, §§ 13(d)-(e) and 14(d)-(e), deals with control share acquisitions
and tender offers. §§ 14(d) and 13(d)
are restricted to § 12 companies. But
there’s an oddity: § 14(e) and the regulations thereunder
apply to tender offers for any security, whether registered or not. For a private company, go to the regulations
for § 14(e) and Rule 10b-13. For a
public company, go to § 14(d) and regulations plus § 14(e) and regulations plus
Rule 10b-13. Most regulation of tender
offers today is under state law but
the federal law is important, too.
There
are two other ways you can become subject to § 13. If you’re a public utility holding company or
an investment company, those statutes incorporate the Securities Exchange Act
of 1934 provisions. Under § 15(d) and regulations
of the Securities Exchange Act of 1934, if you file an effective Securities Act
of 1933 statement, you become subject to § 13.
Now go to 15c-(2)(11), which says that the SEC
has power by regulations to govern quotations for securities on a stock
exchange or the over-the-counter market.
Rule 15c-(2)(11) is mind-boggling, but it has a
simple purpose: before this Rule, if you were a securities broker-dealer and
you wanted to enter into the NASD quotation system, you could do it for quotations
for a company not subject to § 13 of the Securities Exchange Act of 1934. The Rule reverses this: no broker-dealer will
enter quotations for a company not subject to § 13 of the Securities Exchange
Act of 1934 into a quotation system. There
is one exception, which is if a broker-dealer, on his own, gathers material
substantially similar to what would be in the SEC file for a § 13 company, in
which case the broker-dealer can enter quotations. This would be easy for an insurance company
because, for 100 years, state law has required insurance companies to maintain
mountains of public periodic information at the state capitol. It’s difficult aside from insurance companies
to do this.
Hypothetical on § 12(g)
There
is no conflict of interest. We never
represented the person before today. She
should clear it with her boss. She’s the
COO, and she must work for a CEO and the board of directors. Recall the Bernie Ebbers
problem. Bernie found out that a guy was
selling stock without his permission. He
took him out to eat, and when they got back, his office had been cleared out. Consider Rule 10b-5 and R.C. 1707.44: if you
sell securities of an insolvent person and the other side doesn’t know of the
insolvency, that’s a crime under
Would
a § 13(d) report have to be filed? She
owns far less than 5% of the shares outstanding. Why do we raise this issue? The rules under § 13(d) deal with beneficial ownership. Probably no problem there. A § 16(a) report would be due under
Sarbanes-Oxley. It must be done
electronically within two or three days.
This won’t be a problem because most bigger companies have people either
in the corporate secretary’s office or general counsel’s office who are
equipped to make these filings for her, and with advance consultation with
those people she could get them to file the report on her behalf. If she happened to be out of town on the day
that it’s due, she could give those people a signed, written power of attorney
to file the reports. If you’re over 5%,
there will be both a § 13(d) report and a separate § 16(a) report. What’s the theory behind the two
sections? Under § 16(a), the market pays
tremendous attention to what the
insiders are doing. Under § 13(d), it’s
an early warning system of a possible takeover
bid. If you’re over 5%, whether or
not you’re an officer, director, or 10% holder, you’ll have to report. We don’t think there’s a problem under §
16(a). Corporate insiders hate this, but
the system works pretty well according to Shipman.
§
16(b) says that if the client or people within her beneficial ownership range
purchase and sell within a six-month period or sell and purchase within a six month period, then any shareholder
can bring a suit and recapture the difference.
Even if she is pure as the driven snow, it’s no defense. What’s “sale and purchase”? Let’s say that looking back six months over
her beneficial ownership range (that is, your family, trusts and other close
people). We look backwards first and see
if she or anyone in her beneficial ownership range has made a purchase in the
past six months. If it was more than six
months, we look forward. It makes sense
that if she buys stock for $10 and sells for $70, it’s clear she’ll be hit with
$60 per share recapture. But if she
sells for $70 and then purchases for $40, $30 per share will be recaptured. We have to warn her about the future!
Next
up, we go over Rule 144, which never
applies to a company that is never
public. This Rule is very favorable
to public companies and their insiders and those buying in exempt transactions
from insiders. Our client is under Rule
144 even if all the stock she bought was option stock or stock she bought
through a broker on the securities market because she is an affiliate as defined in Rule 405. We make a checklist for the company: are they
current in their § 13 filing? If not, we
can’t use the Rule. Next, we compute her
beneficial ownership (including ownership by her husband and kids and live-in
mother/mother-in-law, family trust, partnership and charitable organizations
that she runs). We look at those people’s
transactions and see if this proposed transaction, coupled with others, will
pass the volume limit test. We explain that it must be a brokers’ transaction. Next, if she has acquired any security in an
exempt transaction from the issuer, there will be a holding period of one year
that will attach. In addition, any
securities of that nature that she has will have a legend on them, and she’ll
have to go to the transfer agent and get securities without a legend because legended delivery is per
se bad delivery. It must be squeaky clean!
She
will have to timely file a Form 144. If
she was over 5%, she would have to do three different filings! In practice, half of the transactions have to
be unwound, but people screw it up. You’ll
be dealing with a local office of the brokerage house. When the Form 144 hits after the transaction, the
The
company may have filed a stop transfer order with the transfer agent because
she’s a #2 officer. How do we deal with
this in advance? The transfer agent will
usually accept the written opinion of internal counsel that it’s okay. Get that file in advance with the transfer
agent. That will eliminate the stop
transfer order. The internal counsel
will usually request the opinion of the personal
lawyer for the officer or director and we can give it. Lastly, the brokerage house that she has got
her to fill out a questionnaire, with one question being: “Are you the officer
or director of a public company?” Many
brokerage houses also require the opinion of the internal counsel for the
company and again, on that opinion, the internal counsel will usually require
our opinion as a condition precedent. It
is a bit complicated, and there is a lot of paperwork.
She
should pick a specific certificate with a high tax basis. She should use specific identification. For § 16(b) purposes, you cannot specifically
identify. A court will pick the stock with the lowest basis. Probably all of her stock has a basis lower
than $70 per share. A lot of it is
probably option stock for which she may have paid $20 or $30 per share. You will have to go over the tax effects with
a tax attorney.
Make
sure to get reasonable diversification of investments! If all our client’s
wealth is in her house and this stock, she would be well advised to sell some
of the stock and diversify her portfolio a bit.
At Enron, there were mid-level executives in just this situation,
holding millions of dollars in Enron stock on January 1 of the year. By the end of the year, the stock was worth
$0.10 per share rather than $70 or $80.
The company looks very good and she seems to have been there a long
time. On the other hand, if all she has
is the house and this, she has lumped all her eggs in
one basket. But on the other, other
hand, if you take out a second mortgage you can deduct the interest for federal
income tax purposes.